Ominous storm clouds darkened in the U.S. this week, as a faltering equity market and weakening dollar joined a troubled Credit market. Globally, there was nothing but distressing news from beleaguered Argentina and Japan. For the week, the Dow dropped 2% and the S&P500 declined 3%. The Transports and Utilities declined 2%, while the Morgan Stanley Cyclical index sank almost 4%. The Morgan Stanley Consumer index dipped just 1%. Selling was broad-based, with the small cap Russell-2000 and S&P400 Mid-Cap indices declining 2%. The technology rally reversed abruptly, with the NASDAQ100, Morgan Stanley High Tech, and Semiconductor indices dropping 4%. The Street.com Internet index sank 7% and the NASDAQ Telecommunications index dropped 6%. The Biotechs were also hit hard, sinking 6% for the week. Considering underlying fundamentals, it is not surprising that financial stocks also came under selling pressure. For the week, the S&P Bank index declined 3% and the AMEX Securities broker/dealer index dropped 4%. With bullion up almost $4, the HUI Gold index added 2%.

Hopes that the Credit market had navigated through the storm were dashed over the past two sessions, with implied yields on agency futures jumping 28 basis points to the highest level in about 5 months. Implied agency yields have now surged more than 110 basis points off of early November lows. For the week, 2-year Treasury yields mustered a 3 basis point decline to 3.15%, with 5-year yields edging one basis point higher to 4.89%. The key 10-year Treasury yield added 18 basis points in the past two sessions to 5.19%, up 3 basis points for the week. Long-bond yields declined 1 basis point to 5.58%. Benchmark Fannie Mae mortgage-back yields rose 2 basis points to the highest level since early August. Considering the record mortgage originations over the past four months, there is an enormous amount of mortgage paper now under water, some considerably. In a potentially problematic development, implied yields on agency futures jumped 10 basis points this week. The spread on the benchmark Fannie Mae 5 3/8% 2011 note widened 2 to 74. The benchmark 10-year dollar swap spread widened 8 to almost 80, its widest level since mid-September. With the dollar dropping 1% this week, we did see the first hints in some time of the systemically problematic confluence of rising rates, widening spreads, and a faltering greenback.

Standard & Poor's Dec. 12, 2001—"Credit card charge-off rates increased in October 2001, according to Standard & Poor's Credit Card Quality Indexes. These indexes monitor the performance of approximately $373 billion in receivables held in trusts of rated credit card-backed securities, which make up nearly two-thirds of the total bankcard market. Issuers distributed October performance data on Nov. 15, 2001. The monthly charge-off rate rose 30 basis points (bps), to 6.8% in October from 6.5% in September. The increase represents a 135 bps increase in charge-off levels compared with a year ago… Delinquencies averaged 5.3% in October, a 20 bps increase from September and a 70 bps increase from a year ago. Seventy-five percent of the trusts tracked by the indexes reported an increase in 30-plus day delinquencies this month, and almost 80% of the trusts reported an uptick in delinquencies in the 90-plus days bucket… Subprime lenders who have witnessed the most rapid growth over the past few years, and have yet to manage through a recession, will feel the increase in losses more directly. These same lenders suffered the greatest absolute increase in losses this month. The average increase in losses in October for prime issuers was relatively modest, less than 40 bps. The subprime section, however, averaged an increase in defaults of 165 bps."

Standard & Poor's Dec. 11, 2001—"Standard & Poor's today placed its single-'B'-minus ratings on various series issued by Home Improvement Loan Trust, Home Equity Loan Trust, Home Improvement & Home Equity Loan Trust, Green Tree Financial Corp., Green Tree Recreational, Equipment & Consumer Trust, and Manufactured Housing Senior/Sub Pass Thru Trust, Green Tree Financial Corp., and Conseco Finance Corp. on CreditWatch with negative implications (see list). Each of the certificates has credit support from a limited guarantee provided by Conseco Finance Corp. and from monthly excess spread. Without the use of the limited guarantee, the monthly excess spread may be insufficient to protect against losses over the life of the transactions. The ratings for the affected classes are dependent upon Conseco Finance Corp.'s ability to provide payments under the limited guarantee."

U.S. Credit quality continues to deteriorate by the week, with Moody's today cutting both Calpine and K-mart debt to junk status. Ratings agencies also downgraded a whole host of Enron-related transactions. From Moody's: "Enron Corp.'s bankruptcy has resulted in the downgrade of lower-rated notes within 18 structured bond transactions…" From Dow Jones' Christine Richard: "Providian Financial, which was reined in by U.S. banking regulators last month after it announced mounting credit losses, faces a tightening liquidity situation…While regulators haven't restricted Providian's ability to raise funds via certificates of deposit, a number of CD brokers have ceased to market the securities. A spokesman for Providian confirmed that Merrill Lynch, Paine Webber and Morgan Stanley Dean Witter no longer quote rates for Providian CDs."

Broad money supply (M3) increased $28.7 billion last week, increasing the 11-week expansion to a stunning $313 billion (19% annualized). Broad money has increased $1.008 trillion, or 14.3%, over the past 52 weeks. Last week's increase was led by a $15.4 billion jump in institutional money market funds, a $9 billion increase in "repurchase agreements," and a $5 billion gain in eurodollars. Institutional money fund assets have increased $167 billion in 11 weeks (79% annualized), and $420 billion over 52 weeks (56%). Total money market fund assets have increased $512 billion, or 28%, over the past 52 weeks.

Fannie Mae's November numbers are out. Business volume (mortgage purchases) was a record $61 billion ($732 billion annualized!) and up 30% from October, with an average yield for retained mortgages at 5.96%. Retained commitments surged to $49 billion, also a record. Year-to-date, Fannie's total book of business is up $224 billion (18% annualized) to $1.539 trillion, with Fannie's outstanding mortgage-backs having increased $136 billion (21%) and it retained portfolio having expanded $89 billion (16%) to $696 billion. Interestingly, Fannie's retained portfolio increased at only a 5% rate during November, a trend worth following closely. The company's delinquency rate increased one basis point to 0.46%. It is worth noting that total outstanding mortgage-back securities expanded at an 18% rate during the past two quarters, compared to 8.7% growth last year. Who is buying this mortgage related paper? During the past three quarters, Credit market instruments held by the securities broker/dealers increased $146.3 billion to $369.9 billion (87% annualized).

Dow Jones Dec. 10, 2001 - "A rush by state and local governments to sell debt issues is making 2001 one of the biggest years ever for sales of new municipal bonds. The borrowing binge, which isn't expected to end soon, was spurred in part by lower interest rates. But even if rates rise, governments will continue borrowing more to help close budget gaps stemming from the impact of a sluggish U.S. economy on state and local revenue, analysts believe…Through the first 11 months of 2001, munibond sales totaled $251 billion, up 40% from the same period in 2000, according to Thomson Financial Securities Data. Sales for the entire year could total $270 billion, the third largest volume on record, analysts say."

Year-to-date, 197 convertible bond deals have been sold for total issuance of $99.4 billion. This compares to 146 deals priced last year raising $61.6 billion, and 112 deals raising $41.3 billion during 1999. Almost $21 billion of converts were issued during October and November, up 66% from last year. Looking at the motley crew of billon dollar plus borrowers, we see Agilent Technologies, Xerox, Cendant, Motorola, Nortel, Sprint PCS, Lucent, Household International, Echostar, Nextel, NTL, Verizon, Calpine, Tyco and, last but not least, Enron. The leveraged speculating community is providing the majority of the demand fueling this boom.

About $5 billion of asset-backed securities were sold this week, increasing year-to-date issuance to $268 billion (up 17% from total record year-2000 issuance). From Wachovia Securities' CDO Weekly: "For the second consecutive week, primary issuance in the high-yield market topped the $2 billion mark with the strong possibility for this week's total to again reach $2 billion in proceeds. The current pace of weekly volume has not been seen since last summer. Last week, 10 transactions were priced totaling $2.4 billion in proceeds. It was again an issuer's market as four issuers were able to price their transactions at the low end of price talk and three were able to upsize transactions or, in a few cases, do both…The market continues to be characterized as cash heavy. Last week AMG reported inflows of $280 million, marking the eighth consecutive week of positive fund flows…"

Between the continued explosion of mortgage credit, and the record issuance of converts and CDO (collateralized debt obligations) instruments, one cannot be the least bit sanguine about the either the quantity or quality of debt issuance. As we have stated before: the intractable problem with the U.S. Credit Bubble is that it by necessity creates too much debt of increasingly poor quality. It is also obvious that the Enron implosion is one more serious blow to this fragile Wall Street "structured finance" edifice. And while the Pavlovian market response has been to rejoice in the heightened liquidity assured by yet another round of financial crisis, after years of incessant overliquefication we have reached the point that the true effects are minimal, fleeting and in the end self-defeating.

And perhaps a weak economy negates the relevance of uncontrolled money market deposit expansion, runaway money supply growth, extreme excesses throughout mortgage finance, unprecedented financial sector speculation and leveraging, and continued booming issuance of suspect Wall Street financial claims, but we just don't think so. Our analysis leads us to fear that the serious structural U.S. financial and economic maladies have yet to surface, and a much more problematic systemic crisis will quite likely commence with the tempering of recent heated but unsustainable money and Credit expansion. Bond market action signals that this is now in the offing, while a shaky dollar would provide confirmation. With this in mind, I will again (my apologies!) plug away at some "old fashioned" monetary analysis, if for no other reason than it is being almost completely ignored by conventional economists with their focus on CPI and GDP. There is, as well, the now long-standing fixation on traditional bank Credit - and the erroneous (dangerous) notion that only banks create money and Credit - to the exclusion of other financial intermediaries that have been the leading instigators of monetary excess throughout this most unusual cycle. I can only assume that this is the explanation for what has been for some time incredible blindness to glaring financial abuses, although I do draw motivation from the belief that unsound economic theory has been a contributing factor. Not only is this environment extraordinary for allowing money and Credit expansion to run completely unchecked, there isn't even discussion as to whether this is a good idea, or hardly a peep that history tell us rather clearly that this is a disaster in the making.

One must again go back decades to locate deep analysis and colorful discussion of the key economic issues of our time - the nature of money, the ramifications for severe monetary excess, and the powerful role played by finance and financial intermediaries. I apologize (again) that the nature of the material is tough sledding. I do, however, believe there is significant pertinent insight to be garnered from slogging through the analysis.

John G. Gurley and Edward S. Shaw (G&S) fired an initial major salvo with their 1955 article in the The American Economic Review (AER): "Financial Aspects of Economic Development":

"Economic development is commonly discussed in terms of wealth, the labor force, output, and income. These real or 'goods' aspects of development have been the center of attention in economic literature to the comparative neglect of financial aspects. Yet development is associated with debt issue at some points in the economic system and corresponding accretions of financial assets elsewhere. It is accompanied, too, by the 'institutionalization of saving and investment' that diversifies channels for the flow of loanable funds and multiplies varieties of financial claims. Development also implies, as cause or effect, change in market prices of financial claims and in other terms of trading in loanable funds. Development involves finance as well as goods."

Importantly, the "radicals" G&S focused directly on the role of financial intermediaries in "transmitting loanable funds between spending units," and the "inadvertent undervaluation by economists of the role that finance plays in determining the pace and pattern of economic growth…"

"A complete set of social accounts would report the flows of loanable funds between spending units and the corresponding changes in financial status… We are deviating from conventional doctrine in regarding the banking system as one among many financial intermediaries… We take exception to the view that banks stand apart in their ability to create loanable funds out of hand, while other intermediaries in contrast are busy with the modest brokerage function of transmitting loanable funds that are somehow generated elsewhere."

"Both banks and other intermediaries have the capacity to create special forms of financial assets that surplus units may accumulate as the reward for restraint on current or capital spending. Banks alone have the capacity to create demand deposits and currency, to be sure, but only savings and loans associations can create savings and loan shares: both 'create credit,' both transmit loanable funds, both enable spending units to diversify their portfolios."

"Banks do have a virtual monopoly of the payments mechanism, and only claims upon monetary intermediaries embody the privilege to use this mechanism. The fact that other intermediaries make use of the payments mechanism, which the banks administer, has sometimes been interpreted to mean that other intermediaries have the inferior role of brokerage in loanable funds… Both types of institutions, on the contrary, are loanable-fund brokers. Both create credit. Whether it is the banks or others which create credit in any period depends not on the banks' role in administering the payments machinery but instead on the preference of spending units for deposits and currency to hold against other financial assets to hold."

"If these other assets are substitutes for the given stock on money in the portfolios of spending units, a demand for them brings nonbank intermediaries to the bond market to compete for bonds with spending units. Then the price of bonds must be higher and the interest rate lower than when banks are the sole intermediaries.

"An additional complexity is that development of financial institutions, including nonbank intermediaries, is both a determined and a determining variable in the growth process."

In an interesting rebuttal - "Intermediaries and Monetary Theory: A Criticism of The Gurley-Shaw Theory", (AER, 1958) - J.M. Culbertson takes issues with G&S's unconventional analysis, but does state, "if these ideas are valid, they call for wholesale revision of our thinking about monetary theory and economic stabilization."

Culbertson recognized the main issue: "Are Commercial Banks Unique in Their Ability to Create Credit?

(G&S) explicitly propose a departure from the usual way of looking at banks in the economy… This difference of view, whatever we may decide is its exact nature, would seem to have policy implications. If commercial banks are not unique, then why should we apply to them a special apparatus of control? …If they are unique in some relevant sense, this cast doubt on the appropriateness of the (G&S) suggestion that…control should aim at all financial intermediaries… and should aim at controlling the total volume of obligations…rather than being limited to bank credit and the money supply. The generally accepted doctrine seems to be that commercial banks are unique…because of two related facts: (1) Commercial banks are the only private institution whose debt serves as a generally acceptable medium of exchange, as money. Money is a unique asset… (2) Because it creates money, the banking system can affect the volume of its liabilities and can create or extinguish credit, or loan funds, in a way that no other financial institution can…The usual view is that intermediaries cannot themselves create credit or loan funds, but rather play a middleman role in conveying to their ultimate users loan funds brought into being by others. Intermediaries perform a function parallel to that of the merchant in other lines; they transmute the debt created by borrowers into something more attractive to lenders." (p. 120)

Culbertson, supporting conventional doctrine that not only won the day but survives to this day, states that "variations as occur in the rate of growth of outstanding obligations of intermediaries arise mainly out of changes in economic and financial conditions that affect the extent to which customers desire to take advantage of the standing offer of the intermediaries, rather than out of any particular decisions or actions on the part of the intermediaries themselves…Discipline over financial intermediaries is exercised in an immediate and direct manner by their creditors. Until someone brings money into a savings and loan association to exchange for its obligation, the association cannot lend money…" On the other hand, "the banking system 'creates credit' by acquiring debt and creating demand deposits to pay for it. The commercial banks do not need 'to borrow loanable funds from spending units with surpluses' in order to extend credit…" (p. 120)

From Culbertson's conclusion: "The theoretical innovations upon which (G&S) have built their argument are radical. If we accept them, we should undertake a drastic reconstruction of banking theory, debt management theory, financial analysis, and the theory of economic stabilization… On the other hand, if the authors cannot convince us of the validity of their theoretical innovations, their main argument and conclusions are untenable. Then, the banking system has not "regressed"… The question is whether the (G&S) theoretical framework is a valid basis for the inquiry, and is an improvement over our accustomed tools of analysis. It seems to me that, on the contrary, it represents a step backwards."

A snippet from G&S's reply: "Our main interests are in analyzing the relationship between real growth and financial growth, in isolating the function of intermediation for special study, and in considering the relative roles during the growth process of monetary and nonmonetary intermediaries... we are interested in relative supplies of direct and (monetary and nonmonetary) indirect debt and in the public's choice between these financial assets." (p. 132/133).

G&S further expanded key aspects of their unconventional analysis in a paper "Financial Intermediaries and the Saving-Investment Process" published in the March 1956 Journal of Finance:

" …It has seemed to be a distinctive, even magic, characteristic of the monetary system that it can create money, erecting a 'multiple expansion' of debt in the form of deposits and currency on a limited base of reserves. Other financial institutions, conventional doctrine tells us, are denied this creative or multiplicative faculty. They are merely middlemen or brokers, not manufacturers of credit. Our own view is different…each kind of non-monetary intermediary can borrow, go into debt, issue its own characteristic obligations - in short, it can create credit…Moreover, the non-monetary intermediaries are less inhibited in their own style of credit creation than are the banks in creating money. Credit creation by non-monetary intermediaries is restricted by various qualitative rules. Aside from these, the main factor that limits credit creation is the profit calculus… The 'multiple of expansion' is a remarkable phenomenon not because of its inflationary implications, but because it means that bank expansion is anchored, as other financial expansion is not, to a regulated base. If credit creation by banks is miraculous, creation of credit by other financial institutions is still more a cause for exclamation." (p. 422)

This is wonderful, strikingly pertinent analysis. Yale's James Tobin was also a prominent player in the "money" and financial intermediaries debate, publishing a series of articles including his classic "Commercial Banks as Creators of 'Money'" in 1963. His article compared the traditional "Old View" with the "New View" championed by Gurley and Shaw:

"A more recent development in monetary economics tends to blur the sharp traditional distinctions between money and other assets and between commercial banks and other financial intermediaries; to focus on demands for and supplies of the whole spectrum of assets rather than on the quantity and velocity of 'money'; and to regard the structure of interest rates, asset yields, and credit availabilities rather than the quantity of money as the linkage between monetary and financial institutions and policies on the one hand and the real economy on the other. (p. 410)

Tobin's work also addressed "The Widow's Curse Myth", concluding "commercial banks do not possess, either individually or collectively, a Widow's Curse which guarantees that any expansion of assets will generate a corresponding expansion of deposit liabilities. Certainly this happy state of affairs would not exist in an unregulated competitive financial world." "Quite apart from legal reserve requirements, commercial banks are limited in scale by the same kinds of economic processes that determine the aggregate size of other intermediaries…there is at any moment a natural economic limit to the scale of the commercial banking industry. Given the wealth and the asset preferences of the community, the demand for bank deposits can increase only if the yields of other assets fall." Central to Tobin's analysis is his view that "the scale of bank deposits and assets is affected by depositor preferences and by the lending and investing opportunities available to banks." "Without reserve requirements, expansion of credit and deposits by the commercial banking system would be limited by the availability of assets at yields sufficient to compensate banks for the cost of attracting and holding the corresponding deposits…The expansion process lowers interest rates generally…but ordinarily not enough to wipe out the banks' margin between the value and cost of additional deposits. It is the existence of this margin - not the monetary nature of bank liabilities - which makes it possible for the economics teacher to say that additional loans permitted by new reserves will generate their own deposits."

That same year Tobin and his Yale associate William C. Brainard co-authored an article, "Financial Intermediaries and the Effectiveness of Monetary Controls" (AER, May 1963), posing the important and still unresolved question: Does the existence of uncontrolled financial intermediaries vitiate monetary control? What would be the consequences of subjecting these intermediaries to reserve requirements or to interest rate ceilings? The paper admittedly addressed these key issues "theoretically and at a high level of abstraction." "The main conclusion can be briefly stated. The presence of banks, even if they were uncontrolled, does not mean that monetary control through the supply of currency has no effect on the economy. Nor does the presence of nonbank intermediaries mean that monetary control through commercial banks is an empty gesture."

Much more interesting, however, were the accompanying AER discussion papers. From noted economist and leading inflation authority Abba P. Lerner:

"It seems to me that a reaction to the historical neglect of nonbank financial intermediaries takes the form of an overemphasis on the similarities between them and commercial banks. The famous proposition that banks differ from other financial institutions in that they can 'create money' and that this is why they have to be regulated while the others need not, is turned around because of this. The (Tobin & Brainard) statement made that 'it is more accurate to attribute the special place of banks among intermediaries to the quantitative restrictions to which banks alone are subjected than to attribute the quantitative restrictions to the special character of bank liabilities,' amounts to saying that banks are not regulated because they create money; they create money because they are regulated.

It is precisely the special quality of banks, or rather of the banking system, that in such an expansion it is quite peculiarly favored by being able largely to count on retaining possession of what is sells and thus to have it available for still further expansion. The explanation of this peculiar power lies, of course, in the banking system's covering such a large part of the financial transactions of the economy that, unlike a relatively small nonbank financial intermediary, it can count on its loans coming back to it somewhere as a deposit. But this 'Widow's Curse' aspect of the banking system is central to the issue. This is the early macroeconomics of the banking theory of money or credit creation that used to be so vehemently denied by outraged microbankers. And without the restrictions, the credit creation or money creation by the banking system would have been much greater than could have been absorbed without severe inflation. That is why even Milton Friedman recognizes the desirability of social control over the creation of money, and why it seems to me more appropriate to say that reserve requirements and other restrictions are imposed on the banking system because it would otherwise have created too much money. The restrictions are responsible for the power of the banking system to create money only in the sense that by preventing the actual creation of money it keeps the potential, the power, of creating money from being used up."

In the greatest (unrecognized) modern irony of monetary theory, I propose that the infamous (but long forgotten) Widow's Curse is anything but a Myth. Moreover, and what makes this so fascinatingly ironic, this phenomenon has been completely missed because of contemporary doctrine's faith that "only banks create money." Nonbanks specifically are not merely "middlemen" as held by conventional thinking and, in reality, have come to possess monetary capabilities of an incredibly powerful nature denied by theorists for decades to exist for even the banking system. In fact, it has not been the expansion of bank deposits that has created an inexhaustible pool ("Widow's Curse") of loanable funds as much as it is the creation of financial sector deposits, especially money market fund intermediation. It is valuable for us to again carefully ponder the previous paragraph from Abba Lerner, and I will attempt to integrate my oft-used example of Fannie Mae borrowing money market fund deposits to finance the purchase of mortgages.

"It is precisely the special quality of…the banking system, that in…expansion it is quite peculiarly favored by being able largely to count on retaining possession of what is sells and thus to have it available for still further expansion."

When Fannie Mae borrows from a money market fund - exchanging a short-term electronic "IOU" for "loanable funds" - and uses this liquidity to acquire mortgages (say from a hedge fund or Wall Street firm), these "loanable funds" (proceeds from the sale to Fannie Mae) are then immediately deposited. This allows the money market fund complex to "retain possession of what it sells" - "loanable funds" - and to have it available to Fannie Mae (or other money market borrowers) for still further expansion.

"The explanation of this peculiar power lies, of course, in the banking system's covering such a large part of the financial transactions of the economy that, unlike a relatively small nonbank financial intermediary, it can count on its loans coming back to it somewhere as a deposit."

The explanation of this peculiar power lies in the money market system's covering such a large part of financial transactions in the securities markets that it can count on its loans for the purchase of securities coming back to it somewhere as a money market fund deposit. It may be helpful to think of the evolution of the money market fund complex as a parallel unregulated "banking" system that has developed concomitant with the expansion of non-bank intermediaries (especially the GSEs, securities firms, Wall Street "structured finance," hedge funds, etc.), with the keen/precarious "advantage" of operating without reserve or capital requirements. While it garners shockingly little attention considering the ramifications, the money market fund complex has attained a virtual monopoly on the payment mechanism for the explosion of securities transactions. One must also appreciate that the vast majority of money fund assets (loans) are liabilities of institutions aggressively leveraging holdings of financial assets - the government-sponsored enterprises, "repurchase agreements" financing securities holdings, short-term loans to securities dealers and various asset-backed/"structured" vehicles. This credit mechanism is quite peculiar as it largely isolates "loanable funds" creation - and deposit expansion - within the securities marketplace. After all, if one borrows in the money market to fund the purchase of securities, the seller will today almost certainly immediately deposit proceeds directly into the money fund complex, where it is immediately available to fund additional loan expansion.

"But this 'Widow's Curse' aspect of the banking system is central to the issue."

This "Widow's Curse" - "which guarantees that any expansion of assets will generate a corresponding expansion of deposit liabilities" - aspect of the U.S. financial system is today paramount to the issue of financial fragility. It is the "Widow's Curse" that has been the key source of finance for an historic financial pyramid. The paradox is that runaway Credit excess directed at the securities markets - with the consequent explosion of broad money supply - can coincide seductively with relatively stable consumer prices. As discussed in recent Bulletins, the analytical focus must be to identify the key "transmission mechanisms" - the "flows of loanable funds" - created through dominant monetary processes. And with the massive Credit inflation prevalent in the U.S. "financial sphere," this has actually only instilled a dangerous complacency in regard to general monetary stability. Amazingly, the Fed to this day continues to aggressively accommodate the most dangerous and unprecedented inflation of financial claims - The Widow's Curse of financial Credit.

And from Tobin: "…The scale of bank deposits and assets is affected by depositor preferences and by the lending and investing opportunities available to banks." Tobin's view of the "Widow's Curse Myth" rests squarely on his analysis that there is a "natural economic limit" to the quantity of banks assets (loans) that, especially created in large amounts, would provide a yield greater than those required by depositors enjoying such strong demand for their "savings." I have no problem with this as it relates to lending to finance real economic investment. But that's certainly not the prominent dynamic of The Great Credit Bubble. Importantly, Tobin's analysis breaks down completely when the key point of monetary injection - the "flow of loanable funds" - is in the securities markets. As we have witnessed, there is no natural limit to the amount of Credit financing the acquisition of assets. In the case of real estate assets, lending excess feeds inflation and only self-reinforcing demand for additional Credit. Even more potent "Widow's Curse" dynamics are prevalent in lending in financial asset markets, where both prices and the stock of securities can be inflated very rapidly, as we have experienced.

From Tobin: "It is the existence of this (lending) margin - not the monetary nature of bank liabilities - which makes it possible for the economics teacher to say that additional loans permitted by new reserve will generate their own deposits."

I would argue that today we operate in an environment with basically unlimited "margin," as uncontrolled money market borrowings at exceedingly low interest rates are used to finance holdings of higher-yielding securities (such as agency notes, mortgage-backs, Credit card receivables, CDO instruments, converts, and corporate bonds). And it is this self-reinforcing explosion of mortgage and asset-backed lending creating the fodder for ever-larger amounts of "spread trades" and other leveraged speculations. Unconstrained by reserve or capital requirements, and thus far with unlimited "margin," the money fund complex (and its GSE and security dealer partners) operate absolutely with a mechanism that guarantees that any expansion of assets will generate a corresponding expansion of deposit liabilities. The Widow's Curse is today no myth, but instead an extraordinarily precarious reality.

And back to Culbertson's rebuttal to Gurley and Shaw:

"Variations as occur in the rate of growth of outstanding obligations of intermediaries arise mainly out of changes in economic and financial conditions that affect the extent to which customers desire to take advantage of the standing offer of the intermediaries, rather than out of any particular decisions or actions on the part of the intermediaries themselves…Discipline over financial intermediaries is exercised in an immediate and direct manner by their creditors.

This analysis also is today categorically inaccurate. The growth of outstanding obligations of intermediaries arises specifically from their aggressive lending activities. Moreover, there is little or no discipline over financial intermediaries exercised directly by their creditors. There is today insatiable demand for money market fund liabilities, as these deposits are perceived to be safe and liquid "money."

And this returns us "full circle" to Gurley and Shaw:

Credit creation by non-monetary intermediaries is restricted by various qualitative rules. Aside from these, the main factor that limits credit creation is the profit calculus…

With implied government guarantees backing the explosion of GSE debt combined with the financial alchemy of contemporary Wall Street "structured finance," the U.S. financial system has enjoyed the capacity of transforming unlimited quantities of risky loans into top-rated liabilities ("money") intermediated through the money market fund mechanism. These processes have completely mitigated what would have traditionally served as restraining "various qualitative rules" and other market forces. And with the Fed "pegging" short-term rates, assuring endless liquidity, and reducing rates aggressively at the first sign of system stress, Credit creation has not yet been in the least bit limited by "profit calculus" or any calculus, for that matter.

And to try to wrap up this difficult analysis, a prescient paragraph from John G. Gurley and Edward S. Shaw: "Financial Aspects of Economic Development," (AER, 1955):

"The lag of regulatory techniques behind the institutional development of intermediaries can be overcome when it is appreciated that 'financial control' should supplant 'monetary control.' Monetary control limits the supply of one financial asset, money. With a sophisticated financial structure providing financial assets…control over money alone is a decreasingly efficient means of regulating flows of loanable funds and spending on goods and services. Financial control, as the successor to monetary control, would regulate creation of financial assets in all forms… 'Tight finance' and 'cheap finance' are the sequels of 'tight money' and 'cheap money.' ***A monetary authority which is tempted to stay within the bounds of its traditional controls because they are quantitative, general, and impartial, may find itself more and more out of touch with credit developments in critical growth areas where lending by nonbank institutions is predominant… Nonbank institutional lenders give rise to special problems in financial control because they are imperfectly competitive and also because they are specialized.***"

In reality, instead of progressing from "monetary control" to "financial control" as was astutely prescribed, the U.S. system basically drifted into a dangerous lack of control of money, credit, or finance generally. We are today in an environment where to even suggest that there should be some control over money and credit expansion is sacrilege. But there is one momentous problem: we are stuck in this Bubble of mounting financial claims, with the leading credit creators being dominating financial institutions specializing in aggressive asset-based lending. And as much as Wall Street would like to trumpet the death of inflation, Wall Street is THE INFLATION, albeit in a most unfamiliar manifestation. At the same time, this financial Bubble could not be more conspicuous; financial fragility could not be more obvious.

"The restrictions are responsible for the power of the banking system to create money only in the sense that by preventing the actual creation of money it keeps the potential, the power, of creating money from being used up." Abba Lerner

Perhaps it is today a case of an uncontrolled monetary system having about reached the point of having its capacity to create "money" "used up." It should be obvious that there are limits to sound monetary expansion. History is so clear on this issue: If money is abused, there's going to be a crisis; at some point there will be a "run" from specious financial claims. Traditionally, such monetary excess would have long ago fueled problematic consumer price inflation, forcing the Fed to have slammed on the breaks. But it truly is different this time, with unique financial structures and inflationary manifestations. Today, the critical issue is the wholesale multiplication of a variety of financial claims not supported by sufficient underlying economic wealth creating capacity. It is a critical U.S. issue domestically, as well as internationally. And make no mistake, the day that depositors question the "moneyness" of these mounting U.S. claims there is a serious systemic crisis. We have also often stated that the U.S.'s momentous relative advantage in creating top-rated securities and "money" has been a key aspect of the dollar Bubble. Unfortunately, there will be no separating the developing problems in Wall Street "structured finance" from confidence in the soundness of the U.S. monetary system. They have become tightly interlinked. This is why I have always associated the "money" issue with the dollar "issue". It then becomes a question of the time remaining - how long will the U.S. financial sector sustain the "power" of creating "money" before it is "used up"? If monetary abuse makes the clock tick faster, the hour hand is in a whirl.